What Rising Rates Mean for Energy MLPs

By Dimitra DeFotis

With higher interest rates front and center on investors’ minds today, Simmons & Co. observations on Master Limited Partnerships are all the more relevant.

In an update on last week’s MLP industry confab hosted by the National Association of Publicly Traded Partnerships, Simmons notes low interest rates have significantly aided pipeline and other midstream MLPs’ raise capital at a reasonable cost, enabling returns well above the cost of capital for these MLPs. That supports cash distribution growth and investor total returns. Cheap credit has fueled the flurry of MLP public offerings, with 96 MLPs now trading. All that liquidity means more ways to own MLPs, including more funds and notes.

So what is the risk as rates rise? Simmons observes:

“While investors should be keenly aware that a change in the interest rate and/or the commodity environment could affect the appeal of the sector, we believe investor interest will continue to grow and the asset class will remain attractive to income-oriented investors who favor growing distribution income. However, given the proliferation of initial public offerings and varying ownership structures, distribution policies and asset portfolios due to expanding definitions of qualifying income, we think the role of due diligence and stock selection will become of greater importance.”

In this week’s Q&A with Darren Schuringa, who manages the Yorkville High Income MLP ETF (YMLP), he noted that “if an MLP’s borrowings are short-end dated, and interest rates start to move up, borrowing costs go up.” That’s why it is important to measure an MLP’s actual distributable cash flow, compared the actual money it pays out, known as its coverage ratio. The higher that ratio, the better. (subscription required)

In an April Q&A with Barrons.com, Kayne Anderson portfolio manager and MLP industry veteran Kevin McCarthy, said the following about the threat of rising rates:

Barrons.com:What is the risk for the MLP equities in a rising interest rate environment?

McCarthy: The answer has two parts: the impact on MLPs’ interest expense, and the impact on their equity values. On first point, on a market-cap weighted basis, the debt structure of MLPs is more than 75% fixed rate. The composition can vary widely, with the large-cap MLPs having very little floating-rate exposure, and some of the very small MLPs having more than 50% floating rate. That’s something we test and monitor closely, though we worry less about it now than we did in 2008 and 2009. Second, MLP equities are yield securities, which generally trade in inverse fashion to interest rates. Over the last 20 years, when you have a sharp spike in rates, you will have a temporary decline in MLP prices. But as opposed to other fixed-income products such as bonds or preferred stock, MLPs can offset rising rates by growing distributions.

Q: And the rate risk for MLP funds?

A: Some funds are benefiting from very cheap, floating-rate debt, some of which is uncommitted, prime-brokerage borrowings. These closed-end funds effectively have double exposure to rising rates, and can be disadvantaged when rates rise. For funds that use prime-brokerage borrowings, when rates rise sharply, their leverage becomes more expensive at the same time that their asset levels are declining. This is obviously a bad combination. Having lived through 2008, we want to have as much long-term, fixed-rate debt as possible and the longest revolving-credit facility commitment as possible. We are the only closed-end fund that has a three-year commitment on its revolver.

Kayne Anderson has four closed-end funds focused on MLPs; the largest is theKayne Anderson MLP Investment Company(KYN). Top five holdings in the fund as of March 31 included some of the largest pipeline players: Enterprise Products Partners (EPD), Kinder Morgan Management (KMR), Plains All American Pipeline (PAA), MarkWest Energy Partners (MWE). The fifth largest holding is now Williams Partners (WPZ). As of Dec. 31, the fifth largest holding was Energy Transfer Equity (ETE).

Amey Stone is Barron’s Income Investing blogger and Current Yield columnist. She was formerly a managing editor at CBS MoneyWatch, MSN Money and AOL DailyFinance. Her responsibilities included overseeing market coverage and personal finance topics. Prior to those roles, she was a senior writer at BusinessWeek where she authored the Street Wise column online and contributed to the magazine’s Inside Wall Street column. Topics covered included economics, corporate finance, Fed policy, municipal bonds, mutual funds and dividend investing. She co-authored King of Capital, a biography of Citigroup Chairman Sandy Weill. She is a graduate of Yale University and Columbia University’s Graduate School of Journalism.